Earnings management by banks through loan loss provisioning during downturns

Abstract

This study investigates whether and how downturns affect earnings management through loan loss provisioning in banks with poor performance. We capture downturns using three different crises that have significantly impacted the banking context, i.e., the Global Financial Crisis, the Sovereign Debt Crisis, and the Covid-19 pandemic. Based on a sample of 1,430 United States and European Union banks, we find that banks with negative pre-managed earnings recognize higher loan loss provisions to adjust downward earnings during downturns. Further tests show that such higher provisions are not significantly associated with future net charge-offs, whereas they are positively associated with future returns on assets. Collectively, empirical evidence suggests that banks with negative pre-managed earnings recognize higher than necessary losses during downturns to report better future performance. This study contributes to previous literature on earnings management by banks and offers insightful practical implications to regulators, policymakers, and investors, who are interested in evaluating the quality of financial reporting.